What is the Ponzi Scheme?
Ponzi scheme is an act of fraud in which investment is made by a potential investors with high expected returns and minimum or no expected risk whereby returns are generated generally for early investors in order to attract new investors and the amount invested by new investors is used to pay off early investors.
Ponzi scheme is a form of deception that attracts investors with a promise to provide more profit in less amount of time with minimum investment. The scheme organizers obtain a return for early investors by making new investors. When the new investor adds money in the scheme, the organizers give back this money in the form of return on investment to those investors who had invested in the scheme initially. In this way, they attract investors to the scheme, thus keeping the cycle on. There is no actual profit in the scheme. This turns out to be a hoax for the person adding money; they promise to generate a high return with little or no risk.
- Depicting assured high return rates with minimal risk.
- The continuous inflow of returns irrespective of the market.
- Unregistered securities with security exchange commission.
- Hidden investment plantings or very difficult to understand.
- No paper trails.
Origin of Ponzi Scheme
This scheme was named after Charles Ponzi, who cheated investors in 1920 with postage stamp scams. Postage prices used to fluctuate constantly, which made stamps to be more expensive in one country than others. It used the benefit of difference in prices by hiring agents to purchase international coupons cheaply in other countries and send back to him. These stamps were sold at a profit at a higher price than originally purchased.
Elements of the Ponzi Scheme
- In order to regularly fund the payouts, the scheme demands a continuous flow of investors.
- Promises made of a high return on investment to induce potential investors.
- Lack of any actual business/ asset, product, or service to sustain promised payouts.
Examples of Ponzi Scheme
- Charles Ponzi, in 1920, came with the buying and selling of international postal stamps.
- Ivar Kreuger, in 1930 came up with this scheme; he was also known as match king.
- MMM is 1990 came up with a Ponzi scheme with an annual return of up to 1000%.
- Caritas scheme in 1991 with eight times return in six months.
- Anubhav teak plantation scam in 1992.
Ponzi Scheme Red Flags
Let’s discuss the following Red flags.
#1 – Unregistered Investment
These schemes generally include those investments which are not registered with state regulators or securities and exchange commission. It is important for the investors to have a registration, which accesses information for the management of the company, its products, services, and finances.
#2 – Complex and Secretive Strategies
Any schemes that have a complex protocol and secret strategies are generally Ponzi schemes. Investors don’t get complete information about the scheme, and the organizer gives a vague knowledge to the investor.
#3 – High Returns with No or Little Risk
An investor should be cautious about the scheme, which promises to give high returns with little or no risk. The investments that yield higher returns involve more risk.
#4 – Unregistered Sellers
State and federal security laws require investment firms and professionals to be registered under certain acts. But most schemes come with unlicensed and unregistered firms and individuals.
#5 – Issues with Paperwork
Whenever funds are not being invested as promised, there will be an error with account statements, which shows that the scheme is a Ponzi scheme. No legal paperwork is available for the investor to examine.
#6 – High Returns Constantly
Investments are never consistent in this scheme. They may fluctuate, so one should be skeptical about the investments that promise high returns every time.
Ponzi Scheme vs Pyramid Scheme
In Ponzi schemes, the money is given to the portfolio manager in lieu of high return, and investors are paid out by funds collected from further investments by later investors, whereas in Pyramid schemes initial schemer recruits other investors, and this cycle goes on and on, and the new investor shares the proceeds with a higher level of the pyramid.
- The initial investors will get their return on investments very soon. Also, the scam artist is responsible for projecting the scheme can earn great value by adding multiple investors.
- These schemes are easy to spot or identify. Each new group of investors made is higher than the previous group, and the scheme formed is basic and simple; hence can be easily identified.
- Various lawsuits are enforced to prosecute strict actions against the organizers of this scheme. Such fraudulent activity is highly punishable in every country.
- The investors who have initially benefited from the scheme and earned maximum profit might reinvest in the scheme to further increase their profits, but this time they might either get a small fortune or no profit at all when the scheme gets dissolved.
- Investments get eroded in the scheme the investors may lose all or part of funds they had invested in the scheme, as it will eventually collapse someday or the other when there are no investors ready to join the scheme.
It is a form of financial fraud where large groups of investors are attracted to scheme for making investments with higher returns and minimal or no risk under which early investors are paid out the return on investment from the funds collected by later investor invested capital. It is not easy to determine whether any investment scheme is a Ponzi scheme or not; hence every investor should be aware of the possibility and should go through all the risks involved in any opportunity put forth.
This has been a guide to what is the Ponzi scheme and its definition. Here we discuss red flags and examples of the Ponzi scheme with their origin, differences. You may learn more about financing from the following articles –